FundamentalAnalysisRedux*

RichardSloanUniversityofSouthernCalifornia

PreliminaryDraft:April10,2018ABSTRACT: In their classic 1934 text Security Analysis, Graham and Dodd warninvestorsagainstsolerelianceonafewquantitativefactorsininvestmentdecisions.Instead, they recommend that investmentdecisionsbebasedona comprehensivefundamentalanalysisoftheunderlyingsecurities.Whiletheirviewsheldswayforalmostacentury,recentyearshavewitnessedasharpreversal.Scholarsoffinanceoften overlook fundamental analysis and their influence has led to a surge ofinvestment products relying solely on a few quantitative factors. These productsoftenhavenamesthatappealtofundamentalanalysis,suchas‘value’and‘quality’.Despite recent advances in quantitative finance, I argue that Graham and Dodd’srecommendationsstillholdtruetoday.Ishowhowpopularquantitativeapproachesto investing overlook important information and select stocks with distortedaccounting numbers rather than temporary mispricing. I conclude that effectivefundamental analysis is essential for efficient capital markets and requires bothgoodfinancialreportingandappropriatelyskilledanalysts.

*ThisessayisbasedonmyinvitedPresidentialScholarAddressatthe2017AnnualMeetinginSanDiego.IthankPresidentDavidBurgstahlerfortheopportunitytogivetheaddressandMaryBarthforinvitingthepublicationofthisassociatedessay.Ithankmymanycoauthorsandothercolleagueswhohavehelpedshapethethoughtsexpressedhere.SpecialmentionstoPatriciaDechow,IliaDichev,U-WenKok,AlastairLawrence,RussellLundholm,JasonRibando,SteveRossi,ScottRichardson,SteveSloan,MarkSolimanandJieyinZeng.Iamsolelyresponsiblefortheviewsexpressedherein.

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I.INTRODUCTIONI have spent much of my career teaching students how to interpret financialstatements. One of my key lessons is that they should not make investmentdecisions based exclusively on a handful of simple financial ratios. Instead, theyshouldconductathoroughanalysisoftheunderlyingbusinessandcarefullyanalyzetheextenttowhichtheunderlyingtheaccountingnumbersreflecteconomicreality.Accounting textbooks are replete with examples of how accounting numbers candistort economic reality. Certain mandated accounting principles simply ignoreeconomic reality. The requirement to expense most investments in research anddevelopment is a case in point. In other cases, managers must choose betweendifferent accounting methods that can poorly reflect economic reality. Examplesinclude different cost flow assumptions and depreciation methods. Finally, manyaccounting principles require managers to make estimates about the future.Exampleshereincludetheallowancesforloanlossesandemployeepostretirementbenefits. These estimates involve considerable subjectivity and are prone tomanagerialbiasandmanipulation.Examples such as those described above probably sound familiar to anyone thatteachesauser-orientedintroductorycourseinfinancialaccounting.Theyareattheheart of fundamental analysis and can be traced back at least as far as thepioneeringwork of Graham andDodd (1934). Consequently, I suspect thatmanyaccounting academics believe that fundamental analysis is alive andwell. Yet thefield of academic finance and the investment world today are increasinglydominatedbyquantitativeinvestmenttechniques.Thesetechniquestypicallyselectsecurities using a few simple ratios and portfolio optimization software. Recentchanges have been so profound that they recently led theWall Street Journal toproclaimthat‘TheQuantsRunWallStreetNow’.2Quantitative investingstrategiesareoftenreferredtoas ‘rules-based’strategies.Acommonexampleistheselectionofaportfolioofstockswithhighbook-to-marketratios. The advantages of such strategies arewell documented. These rules-basedstrategies can quickly and efficiently select securities from a large investmentuniverse.Incontrast,thetraditionalfundamentalanalystcantypicallyonlyanalyzeasmallsubsetoftheinvestmentuniverse.Quantitativestrategiesarealsoobjective,thus avoiding the well-documented behavioral biases affecting many humaninvestors,suchaschasingglamorstocksorholdingontolosingstocks.These advantages aside, however, many of today’s quantitative investmentstrategies seem surprisingly naïve. They ignore the basic rules of fundamentalanalysis, taking accounting numbers at face value and assuming that they reflecteconomicreality.Moreover,sincemanyoftherulesusedbyquantitativeinvestment2SeeWallStreetJournal,May21,2017.Availableathttps://www.wsj.com/articles/the-quants-run-wall-street-now-1495389108.

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strategiesarewellknownandwidely implemented, it ishardtoseehowtheycancontinuetoprovidesuperiorinvestmentperformanceincompetitivemarkets.My goal in this paper is to reaffirm the importance of fundamental analysis forsound investment decision-making, well-functioning capital markets and efficientresourceallocation.Iacknowledgetheadvantagesofquantitativeinvestmenttools.But I question whether the simple and well-known rules-based strategies thatincreasinglydominate today’s investing landscapeareagoodsubstitute forsoundfundamentalanalysis.

II.ABRIEFHISTORYOFFUNDAMENTALANALYSISFundamentalanalysisisamethodofevaluatingasecurityinanattempttomeasureits value, by examining related economic, financial and other qualitative andquantitativefactors.3ThehistoryoffundamentalanalysiscanbetracedbackatleastasfarasthepioneeringbookonthetopicbyGrahamandDodd(1934).Thisbookwas published in the aftermath of the stock market crash of 1929 and warnedinvestorsandagainst speculative investmentbehavior. Instead,GrahamandDoddencourageinvestorstodevotetheirattentionto:

“the field of undervalued securities-issues,whetherbondsor stocks,whicharesellingwellbelowthelevelsapparentlyjustifiedbyacarefulanalysisoftherelevantfacts”[page13]

Graham and Dodd popularized the term ‘intrinsic value’ to represent the valuejustifiedbyacarefulanalysisoftherelevantfacts.4Indescribingtheirapproachtodetermining intrinsic value, they emphasize the importance of considering bothquantitativeandqualitativefactors.Chapter2isdevotedtothistopicandconcludesthat:

“In themathematicalphrase, a satisfactory statistical exhibit is anecessarythough by nomeans a sufficient condition for a favorable decision by theanalyst”[p.40]

GrahamandDoddalsoemphasizetheimportanceofanalyzingthecompanyreportsthat publish the financial and operating figures underlying an investment. In thisrespect, they identify inadequate or incorrect data as a principal obstacle to thesuccessoftheanalyst,recognizingthat:

3IobtainedthisparticulardefinitionfromInvestopedia,availableathttps://www.investopedia.com/terms/f/fundamentalanalysis.asp.Otherdefinitionsareavailableandconveythesamebasicidea.4Theterm‘intrinsicvalue’canbetracedbackatleastasfarasArmstrong(1848).

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“Deliberate falsification of the data is rare;most of themisrepresentationflows from the use of accounting artifices which it is the function of thecapableanalysttodetect”[p.20]

Much of the text in Graham andDodd is devoted to techniques for analyzing thefinancialstatements.Pages299through542ofthetextaredevotedtotheanalysisof common stock investments. Of these 243 pages, 192 pages are devoted totechniques for analyzing the income statement and balance sheet. These pagescover such topics as special items, depreciation, amortization and unconsolidatedsubsidiaries. It is instructive to note that many of the accounting issues coveredhave since been at the heart of major corporate scandals, including WorldCom,EnronandValeantPharmaceuticals.The techniques of fundamental analysis advocated by Graham and Dodd werebroadlyembracedbytheinvestmentcommunityandplantedtheseedsfromwhichthefinancialanalystprofessionwouldgrow.PriortoGrahamandDodd,thefinancialanalystprofessionwasvirtuallynon-existent.5FollowingthepublicationofGrahamand Dodd, the financial analyst profession grew and flourished. The New YorkSocietyofSecurityAnalysts (NYSSA)was founded in1937andpublished the firstissueofTheAnalystsJournalin1945.Thefirstnationalorganizationwasestablishedin1947,when several regional societies voted to form theNational FederationofFinancial Analysts Societies. The Federation was subsequently renamed theFinancial Analysts Federation (FAF) and The Analyst Journal was subsequentlyacquiredbytheFederationandrenamedtheFinancialAnalystsJournal.In1959,theInstitute of Chartered Financial Analysts (ICFA) formed to administer the CFAexaminationandcertification,withthefirstexaminationstakingplacein1963.TheFAFandtheICFAsubsequentlymergedtoformwhatiscurrentlytheCFAInstitute.Membershiphasgrownfromjust8,000in1963toover135,000today.Throughouttheremainderof thetwentiethcentury, fundamentalanalysiswasthedominant approach to investing. The CFA curriculum had a strong focus onfundamental analysis. Industry giants such as Fidelity and PIMCO built theirbusinessesonaninvestmentphilosophygroundedinrigorousfundamentalanalysisandleadinginvestorsoftheera,suchasWarrenBuffetandJohnNeff,werestrongadvocatesoffundamentalanalysis.OnWallStreet,alargecadreofsell-sideanalystsevolved to conduct fundamental analysis on companies and provide investmentrecommendationsandfinancialstatementforecaststoinvestors.Yet this same period also marked the beginning of the shift from fundamentalanalysis to a more quantitative approach to investing. The shift began withdevelopments in academia including modern portfolio theory (see Markowitz,1952), the Capital Asset Pricing Model (see Sharpe 1964 and Lintner 1965), the

5TheNewYorkSocietyofFinancialStatisticianswasfoundedin1916,theInvestmentAnalystsSocietyofChicagowasfoundedin1925andtheSecurityAnalystsofSanFranciscowasfoundedin1929respectively.

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efficient market hypothesis (see Fama, 1970) and derivative pricing theory (seeBlack and Scholes 1973). One of the earliest challenges to fundamental analystscame from Fama (1965) in the Financial Analysts Journal. In this article, Famadiscusses the implications of the theory of random walks for stock prices,concludingthat:

“If the randomwalk theory is valid and if security exchanges are ‘efficient’markets,thenstockpricesatanypointintimewillrepresentgoodestimatesof intrinsicor fundamentalvalues.Thus, additional fundamentalanalysis isonly of value when the analyst has new information which was notconsideredinformingcurrentmarketpricesorhasnewinsightsconcerningtheeffectsofgenerallyavailable informationwhicharenotalready implicitin current prices. If the analyst has neither better insights nor newinformation, hemay aswell forget about fundamental analysis and choosesecuritiesbysomerandomselectionprocedure.”[p.59]

These insights from academia have gradually been incorporated in the CFAcurriculum,thoughtechniquesoffundamentalanalysiscontinuetobeastapleofthecurriculum.Academictextbooksoninvesting,however,havemadeasharperswitchfrom a focus on fundamental analysis to a focus on these more recent academicinsights.ThisshiftisillustratedbythecoverageofBodie,KaneandMarcus(2017),whichiscurrentlythe‘standard’textbookforbusinessschoolcoursesoninvesting.Thetextbook’scontentsaresummarizedasfollows:

“The integrated solutions forBodie,Kane, andMarcus' Investments set thestandard for graduate/MBA investments textbooks. The unifying theme isthat securitymarkets arenearly efficient,meaning thatmost securities arepriced appropriately given their risk and return attributes. The contentplacesgreateremphasisonassetallocationandoffersamuchbroaderanddeeper treatmentof futures,options,andotherderivativesecuritymarketsthanmostinvestmenttexts.”6

Inordertoexemplifythisshift,Table1comparesthenumberofchaptersfocusingonvarious investment topics inGrahamandDodd(1934)versusBodie,KaneandMarcus (2017). The main take away is that there has been a shift away fromfinancial statement analysis and toward more recent academic innovations infinance. In noting this shift, it would be remiss of me not to acknowledge thetheoretical rigor and practical importance of these academic insights and themasterful jobdonebyBodieetal. in summarizing these insights for students.Butmy main purpose here is simply to illustrate that investment texts increasinglyassumethatpricesalreadyreflectfundamentalsandusethisasastartingpointforintroducingmorerecentacademictheoriesoninvesting.7

6Obtainedfromhttps://www.amazon.com/Investments-Zvi-Bodie-Professor/dp/1259277178.7WhileGrahamandDodd(1934)obviouslydidnotcovertopicsdevelopedlongafterpublication,itdoesanticipatesomesuchtopics.Forexample,thebookcontainsasectionon‘discrepanciesbetween

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Table1.SummaryofTopicsCoveredinGrahamandDodd(1934)andBodie,KaneandMarcus(2017)

FinancialStatementAnalysis

PortfolioTheory&

Management

AssetPricingTheory

EfficientMarket

Hypothesis

DerivativePricingTheory

GrahamandDodd(1934)

15Chapters

Bodie,KaneandMarcus(2017)

1Chapter 9Chapters 3Chapters 2Chapters 4Chapters

With this shift of focus in the teaching of courses on investments, the teaching offundamentalanalysisismigratingtoaccountingdepartments.Astrongbackgroundin accounting and fundamental analysis is not typically a requirement for eitheracquiring a doctorate in finance or teaching a course on investments. To fill thisvoid, many accounting departments now offer courses covering fundamentalanalysis and the associated textbooks are increasingly authored by accountingfaculty.8 The academic accounting journals are also home tomuch of the ongoingresearchrelatingtofundamentalanalysis.

III.ABRIEFHISTORYOFQUANTITATIVEANALYSISInthissection,Iprovideabriefhistoryoftheemergenceofquantitativeinvesting.My focus isonequity investmentstrategies thatutilizeaccountingnumbers, sincethese strategies compete most directly with fundamental analysis. The materialpresented in this sectiondrawsheavilyonKok,RibandoandSloan (2017),whichprovides a history of formulaic value investing and documents some of itsdrawbacks.As Iwill describe inmoredetail below, formulaic value investingwasthe earliest and is currently the most prominent form of a quantitative equityinvesting.Quantitativeinvestmentstrategiesfirstbeganappearingwithsomeregularityinthe1980s, though theregrowthcanbe tracedback to the1960s, andparticularly thedevelopment of the CRSP database at the University of Chicago. CRSP provided acomprehensivepanelofstockreturndatathatfacilitatedthequantitativeanalysisofinvestment strategies (e.g., backtests). Early work using the CRSP databasepriceandvalue’,whichincludesaforerunneroftheShillerCAPEratiomarkettimingstrategy.GrahamandDoddalsoincludescoverageofstockwarrants,notingthatwarrantswithnoexercisablevalue‘haverealvaluenonetheless…fortherighttobenefitfromanyincreaseinthepriceofthestock’.Themainthrustoftheiranalysisofthestockwarrant,however,isasa‘fundamentallydangerousandobjectionabledevicebecauseiteffectsanindirectandusuallyunrecognizeddilutiononcommonstockvalues’.8ExamplesincludePalepuandHealy(2012),Penman(2012),HolthausenandZmijewski(2013)andLundholmandSloan(2017).

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supported the view that stockmarketswere generally efficient,with stock pricesfully reflectingpublicly available information (Fama,1970).Gradually, however, anumber of anomalies emerged whereby future stock returns appeared to bepredictable based on publicly available information. Many of the prominentanomalies involved accounting data. Examples include the earnings-to-price ratio,the book-to-market ratio and accounting accruals. Moreover, many of theseanomalies could be rationalized as systematic, albeit naïve, applications offundamentalanalysis.Forexample,thebook-to-marketratioisoftencharacterizedasaformofvalueinvesting(e.g.,FamaandFrench1998).Theemergenceoftheseanomalieswasparalleledbytheintroductionofaseriesofrelated ‘style’ or ‘factor’ indices. Russell Investments introduced the first styleindices in 1987, which were named the ‘price-driven index’ and the ‘earningsgrowthindex’respectively.Theoriginalideawasthattheprice-drivenindexwouldprovide a suitable benchmark for traditional value investors seeking underpricedstocks, while the earnings-growth index would provide a good benchmark forgrowth investors seeking stocks with high upside potential. The originalmethodologyrankedstocksintheunderlyingindexusingthebook-to-marketratioandplacedthetophalf(bymarketcapitalization)intheprice-drivenindexandthebottomhalfintheearnings-growthindex.Intheyearssince,Russellhasrefinedthemethodology and renamed the price-driven index as the ‘value index’ and thegrowth-driven index as the ‘growth index’. Other index providers, included S&P,MSCIandCRSPhavesince followedsuit,witheachproviding theirownvalueandgrowthindicesusingtheirownmethodologies.While the original idea behind these indices was to provide benchmarks forevaluatingactiveportfoliomanagers,fundsreplicatingtheindicesthemselvessoonemerged.The firstvalueandgrowth index fundswere introducedbyVanguard in1992.The1994prospectusdescribestheinvestmentobjectivesofthevaluefundasfollows:

“The VALUE PORTFOLIO seeks to replicate the aggregate price and yieldperformanceoftheS&P/BARRAValueIndex,anindexwhichincludesstocksintheS&P500Indexwithlowerthanaverageratiosofmarketpricetobookvalue.Thesetypesofstocksareoftenreferredtoas"value"stocks.”

From these humble beginnings, index-based value funds proliferated and arerapidlyovertakingtheiractivelymanagedcounterpartsinthevalue-investingarena(seeKoketal.,2017).Moreover,themarketingmaterialassociatedwiththesefundsincreasingly promote them as vehicles for investing in potentially underpricedstocks. For example, the current Vanguard Value Index Fund’s product summarystatesthat“thesestocksmaybetemporarilyundervaluedbyinvestors”.9

9Quoteobtainedfromhttps://personal.vanguard.com/us/funds/snapshot?FundId=0006&FundIntExt=INT&funds_disable_redirect=true.

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Followingthesuccessofindex-basedvaluestrategies,indiceswerecreatedtotrackthe performance of other prominent anomalies discovered in the academicliterature.Featuringprominentlyamongtheseareindicestrackingmomentumandquality.These indicesaretypicallyreferredtoas ‘factor indices’or ‘smartbetas’. Iwill focus here on the quality factor, since this factor relies most heavily onaccountingdata.The quality factor is not well defined and serves as something of a catchall forvarious anomalies that are based on accounting data. Table 2 summarizes theimplementation of the quality factor for nonfinancial stocks by threemajor indexproducers. All of the index producers include a variant of accounting return oninvestment.ThisismotivatedbytheworkofNovyMarx(2013)andothersshowingthat accounting rates of return on investment predict future stock returns inbacktests. Twoof theproducers includemeasures of leverage,withhigh leveragerepresenting lower quality. FTSE Russell includes accruals and change in assetturnover,bothofwhicharemeasuresofpotentialbalancesheetbloatthathavehada negative relation with future profitability and stock returns (see Sloan 1996;Richardson et al. 2006). Fidelity includes the cash flowmargin, which also helpsmitigate the impact of balance sheet bloat on earnings-based performancemeasures. MSCI and Fidelity also include tilts against volatility with earningsvolatilityandcashflowstabilityrespectively.Table2.Implementationofthe‘QualityFactor’byThreeMajorIndexProducers.(+)indicatesthatahighervaluesignifieshigherquality,while(-)signifiesthatahighervaluesignifieslowerquality.IndexProducer MeasuresofQualityMSCI Return on Equity (+), Debt-to-Equity (-), Earnings

Variability(-)FTSERussell Return on Assets (+), Change in Asset Turnover (+),

Accruals(-),Industry-RelativeOperatingCashFlowtoDebt(+)

Fidelity FreeCashFlowMargin(+),Returnon InvestedCapital (+),FreeCashFlowStability(+)

Investmentfundstrackingqualityindiceshaveproliferatedinrecentyears.AsearchonFirstBridgeusingtheterm‘quality’revealedover30quality-basedETFs.10ThelargestoftheseistheiSharesEdgeMSCIUSAQualityFactor,withover$4.5Bundermanagement.The latest trend in index-based factor ETFs ismultiple factor investing. The ideabehind these funds is to provide exposure to several factors in one product. ThemostpopularfamilyofindicesherearetheMSCIDiversifiedMultiple-FactorIndices.Theseindicesaimtomaximizeexposuretofourfactors–Value,Momentum,Quality10Seehttp://www.firstbridgedata.com/.

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and Low Size. The most popular product in this space is the iShares Edge MSCIMultifactorIndex,withabout$1Bundermanagement.Our discussion of quantitative investing this far has focused on index-basedproducts.Suchproducts,however,representjustthetipoftheiceberg.Themajorityofinvestmentmanagersusingrules-basedquantitativestrategiesemploytheirownproprietarystrategies.ThelargestmanagersinthisspaceincludeDimensionalFundAdvisors, AQR Capital Management, Arrowstreet Capital, Acadian AssetManagement and Quantitative Management Associates. Collectively, they managehundreds of billions of dollars. Quantitative strategies are also being activelyembraced by the largest investmentmanagement companies including Blackrock,VanguardandFidelity,withallthreenowofferingasuiteoffactor-basedinvestmentproducts. It therefore comes as no surprise that theWall Street Journal recentlyproclaimedthat‘TheQuantsRunWallStreetNow’.11

IV.APERSPECTIVEONQUANTITATIVEINVESTINGMy brief histories of fundamental analysis and quantitative analysis shouldillustrate how approaches to investing have come almost full circle since thepublicationofGrahamandDoddin1934.GrahamandDodd’soriginaltextcautionedagainstmaking investments purely on the basis on a handful of metrics, such asbookvalueandearnings.Instead,theyrecommendthatinvestorsundertakeamorethoroughfundamentalanalysistodetermineintrinsicvalue.Withtheadventoftheefficient markets hypothesis (EMH), investors were encouraged to assume thatprices already reflected intrinsic value and concentrate of forming appropriatelydiversifiedportfolios.Thisledtothepopularityofindexing.Subsequently,researchontheEMHuncoveredvariousanomalies,wherebysubsetsofstockswithspecificcharacteristicswere shown to have outperformed the broadermarket. Several ofthemostrobustanomalieswerebasedonaccountingnumbers.Appealingtoassetpricingtheory,thesemetricshavebeenusedtocreateinvestmentproductsthatarelabeled as ‘factors’ and ‘smart betas’. Monikers are attached to these factors thatassociate them fundamental analysis, such as ‘value’ and ‘quality’ and they aremarketedasstrategiesthataredesignedtoyieldsuperiorinvestmentperformance.This brings us back to the issue of market efficiency. Why should simple, well-knownandreadilyavailablestrategiestoconsistentlygeneratesuperiorinvestmentperformance in competitive markets? It seems counterintuitive to argue thatfundamentalanalysistoidentifydiscrepanciesbetweenpriceandintrinsicvalueisunlikely to identify mispriced securities, while simultaneously arguing that aninvestment strategy based on the book-to-market ratio systematically identifiesmispricedsecurities.

11SeeWallStreetJournal,May21,2017.Availableathttps://www.wsj.com/articles/the-quants-run-wall-street-now-1495389108.

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Koketal.(2017)addressthisissuedirectlyinthecaseofformulaicvalueinvesting.Theyshowthatclaimsabout theoutperformanceof formulaicvaluestrategiesareoverstated. For U.S. markets, they find no compelling evidence to support theoutperformanceofformulaicvaluestrategies.Moreover,theypointoutthatnoneofthemajorcommerciallyavailableU.S.valueindiceshaveshownconsistentevidenceofoutperformanceoverthepastdecade.Ifformulaicvaluestrategiesarenotidentifyingmispricedstocks,thenwhataretheyidentifying?Koket al. show that these strategies systematically identify securitieswith temporarily inflated accounting numbers. For example, a strategy of buyingstocks with high book-to-market ratios systematically identifies stocks withtemporarily overstated book values that are subsequentlywrittendown. Inmanycases,theseoverstatedbookvaluesarisequitetransparentlyfromaccountingrulesthatfailtoreflecteconomicreality.Forsuchreasons,GrahamandDodd(1934,p.17)dismissedinvestingonbookvalueas‘almostworthless’.Iwillprovideacasestudytoillustratethisphenomenoninthenextsection.Proponentsofquantitativeinvestingoftenrespondtothelimitationsofinvestingonsimple value ratios alone by supplementing themwith other factors, such as thequality andmomentum factorsmentionedearlier (seeAsness et al. 2015).On thefaceofit,thisseemslikeagoodidea.Theshortcomingofsimplevaluationratiosisthat they tend to be high for companieswith deteriorating financial performancethathasbeenincorporatedinprice,buthasnotyetincorporatedintheaccountingnumbers. Supplementing valuation formulas with market-based metrics, such asmomentum, should help to weed out the companies with deteriorating financialperformance. But the same basic question remains. If such strategies are wellknown, easy to implement and readily available to investors, why should theyconsistentlygeneratesuperiorinvestmentperformanceincompetitivemarkets?We can shed some evidence on the above question by examining the history of amajorindexthathasbeendesignedtoreplicateamultiplefactorinvestingstrategy.TheMSCIUSADiversifiedMultiple-FactorIndexaimstomaximizeexposuretothevalue,momentum,qualityandlowsizefactorswhilemaintainingtheriskprofileofabroadUS index.Backtests indicate that thiscombinationof factorshasprovidedahigherreturn than theoverallmarket.Forexample,betweenNovember1998andtheFebruary2015launchdateoftheindex,backtestsindicatedthattheindexhadimpressivelyoutperformedthebroadermarket.Yetsinceitslaunchdate,theindexhas closely tracked and slightly underperformed the broadermarket.12Moreover,much of the backtest outperformance came from the earlier part of the backtestperiod. Some readersmaywonderwhat fundamental insights couldbemissedbythis multiple-factor index. How could a portfolio of small cap stocks with lowvaluations, high quality and strong price momentum not generate superior

12ThiscommentaryreflectsperformancethroughtheendofFebruary2018.Seehttps://www.msci.com/documents/10199/15f5d610-5ecc-4bc5-850c-5a9857928267forafactsheetonthisindex.

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performance?Iwillprovideacasestudyinthenextsectiontoillustratehowsuchascreencanmissimportantfundamentalinsights.Quantitative investment strategies are usually recommended on the basis ofimpressive backtest performance. Yet there are several reasons to be skeptical ofbacktestresultsasindicatorsoffutureperformance.Idiscusseachinturn:DataMining(p-hacking)Wetypicallyonlygettoseebackteststhatworked.Ifresearchersconductmillionsofbacktests,somewilluncoverstrategiesthatgeneratedhighreturnsbychancealone.Butthereisnoreasontothinkthatsuchstrategieswillworkinthefuture.Recentresearchconcludesthishasbeenaseriousprobleminfinanceandthatmanyofthe‘anomalies’thathavebeenuncoveredinpriorresearcharelikelyduetodatamining(see Harvey 2017, Linnainmaa and Roberts 2017, Hou, Xue and Zhang 2017 andChordia,GoyalandSaretto2017).CompetitionPerhapsthemostcompellingreasonnottoexpectanywell-documentedandeasilyreplicable investment strategy to generate consistently superior investmentperformance is competition. My own work on the “accruals” strategy in Sloan(1996)isagoodexamplehere.Thestrategyinvolvesbuyingstockswithhighcashflowsbutlowearningsandsellingstockswithlowcashflowbuthighearnings.Theidea is that investors tend to fixate on current earnings when forecasting futureearnings, ignoring important information in cash flows.Thestrategyworkedwell.Theideawasinitiallyeffectiveinpredictingfutureearningschangesandinvestorsdidnotseemtofullyappreciatethisidea,sothestrategyalsopredictedfuturestockreturns.Sincepublication,theideahascontinuedtoworkwellinpredictingfutureearnings changes , but it no longer seems so effective in predicting future stocksreturns (seeGreen,Hand and Soliman, 2011). The fact that it still predicts futureearningssuggeststhattheideahasmeritandwasnotjustdatamining.Whatseemsto have happened here is that the strategy becamewidely known and exploited,resultinginitsdemiseforpredictingstockreturns.ResearchbyPontiffandMacLean(2016) provide comprehensive evidence that performance of academic tradingstrategiesdeclinesafterpublication.ImplementionCostsBacktest results ignore many of the real-world costs and frictions involved inexploiting an investment strategy. This is particularly true in small and illiquidsecurities.Thebid-askspreadandthepricepressurethatwouldhaveresultedfromadditional tradesare twopotentially largebutdifficult toquantifystocks.Costsofshort selling are also relevant to strategieswhere the gains come from the shortside.Koketal.(2017)provideevidencethattheabnormallyhighbacktestreturnstosmallcapvaluestrategiesareprimarilyattributabletoshort-sellinggrowthstocks.

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They show that these same stocks can be difficult and expensive to short sell inpractice, issues that are ignored in the backtests. It is alsoworth noting that theownersofthesestockscanlendthemoutandcollectalendingfee.Thislendingfeerepresents income generated by the stock in much the same way as dividendsrepresent a form of income on dividend-paying stocks. Yet backtests typicallyincludedividendincomebutignorelendingincome.Iwill close this sectionby summarizingmyperspective onquantitative investing.First, quantitative tools have undoubtedly improved the ability of investors tosystematically identify and exploitmarket inefficiencies. Quantitative tools can beused to enhance fundamental analysis and they are particularly helpful inidentifyingandexploitingsystematicbehavioralerrorsoroversightsthataremadeby many investors. The key drawback of quantitative investing strategies is thatonce they are well-known and readily accessible, competition is likely to renderthemobsolete.Inthisrespect,mythoughtsgobacktoFama’s(1965)wordsontheimplications of market efficiency for fundamental analysis. Successful investmentstrategiesincompetitivemarketsrequireeithernewinformationofbetterinsights.Wellknownandreadilyavailablequantitativestrategiesofferneither.

V.CASESTUDIESIntheprevioussection,Iarguethatrules-basedquantitativeinvestmentstrategiescanmissimportantquantitativeandqualitativeinsightsthatcanhaveimplicationsforfutureperformance.Incompetitivemarkets,sophisticatedinvestorsconductingrigorous fundamental analysis typically uncover these insights and so they arereflected in security prices. Consequently, quantitative investment strategiesidentifystocksthatmaysuperficiallylooklikegoodinvestments,butinrealitycanhaveseriousproblemswithdireimplicationsforfutureperformance.In this section, I outline two case studies to illustrate the pitfalls of quantitativeinvestmentstrategies.ThefirstcasestudylooksatWhitingPetroleumCorporation,anoilandgascompany, in2015.Thiscasestudyillustrateswhytherewasalargerotationofenergystocksfrom‘growth’indicesin2014to‘value’indicesin2015.13Whiting’s book-to-market ratio rose above 2 in 2015. But this had nothing to dowith price falling below intrinsic value. Instead, vagaries of the accounting rulescausedWhiting’s book value to deviate significantly from its intrinsic value. Thesecond case study looks at Big Five Sporting Goods, a sporting goods retailer, in2017.Thisstockrosetothetopofgeneric‘multiple-factor’investmentstrategiesatthe beginning of 2017. This case will illustrate how multiple-factor quantitative

13Thisrotationisdiscussedinhttp://www.ftserussell.com/files/press-releases/ftse-russell-announces-preliminary-lists-2015-russell-indexes-reconstitution.WhitingPetroleumexperiencedasimilarshift.ThisstockwasheldbytheVanguardGrowthIndexFundandtheVanguardMidCapGrowthIndexFundupuntilJune2015.BetweenJune2015andDecember2015,itwasmovedoutofthesefundsandputintheVanguardSmallCapValueIndexFund.

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strategies can miss important information with negative implications for futureperformance.CaseStudy1:WhitingPetroleumWhitingPetroleumisanindependentoilandgascompanyengagedindevelopment,production,acquisitionandexplorationactivities,primarilyintheRockyMountainsRegion of theUnited States.Whiting’smajor assets are the proven reserves of itsportfolio of oil and gas properties. Table 3 below summarizes data relating toWhiting’s financial position from 2013 through 2016. Note that the standardizedvalueofWhiting’sprovenoilandgasreservesplummetedfrom$10,843Mattheendof2014to$4,574Mattheendof2015.ThiswasaccompaniedbyasharpdeclineinWhiting’smarketcapitalizationfrom$5,507Mto$1,927M.Thedifferencesbetweenthe values of the proven reserves and the market capitalizations are largelyexplainedby the fact thatWhitingwas financedbyabout$5,000Mofdebtduringthisperiod.ThedeclinesinboththevalueofWhiting’sreservesanditsmarketvalueweredrivenbyasteepdropinthepriceofoil.Thepriceforabarrelofoilhadbeeninexcessof$100abarrelduringthefallof2014,buthadplummetedto$55bytheendof2014andhadfurtherdroppedto$34bytheendof2015.Table3.SummaryInformationonWhitingPetroleum’sFinancialPositionBetween2013and2016.AllamountsexceptProvedReservesarein$millions.EndofCalendarYear

ProvedReserves(MillionBarrelsof

OilEquivalent)

StandardizedDCFMeasureofProvedReserves

NetBookValueofPP&E

(PrimarilyO&G

Properties)

BookValueofCommonEquity

MarketValueofCommonEquity

2013 438.5 6,594 7,595 3,837 7,3412014 780.3 10,843 12,143 5,703 5,5072015 820.6 4,574 10,750 4,759 1,9272016 615.5 2,698 9,143 5,149 4,351

GiventhatWhiting’smajorassetwasitsprovenreservesofoilandthatWhitingwasso highly leveraged, it makes sense that Whiting’s stock price plummeted inresponsetothecollapseinthepriceofoil.YetitisalsoapparentthatthenetbookvalueofWhiting’sPP&Eand theassociatedbookvalueof commonequitydidnotdropbynearlyasmuch.ThiscausedWhiting’sbook-to-marketratiotorisesharply.Figure1showshowWhiting’sbookvaluepershareandstockpriceresponded tothedropinthepriceofoil.WhileWhiting’sstockpricerespondedtothedropinthepriceofoilinatimelymanner,Whiting’sbookvaluerespondedmuchmoreslowly.Whitingdidnot recordan impairment to itsoil andgaspropertiesuntil the thirdquarter of 2015, and the impairment only amounted to about $10/share, eventhoughthedeclineinthepriceofoilhadwipedoutabout$70/sharefromWhiting’s

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stockprice.ThiscausedWhiting’sbook-to-marketratiotoincreasefromaround0.4inmid2014to2.0justbeforethewrite-downanddowntoaround1.0immediatelyafterthewrite-down.Figure1.GraphofPrice/ShareandBookValue/ShareforWhitingPetroleumversusthePriceforaBarrelofOilfrom2014through2017.

Those familiarwith the accounting for oil and gas properties should realizewhathappened here.Whiting uses the ‘successful efforts’method to account for its oilandgasproperties.ThismeansthatwhenWhitingdiscoversacommerciallyviableproperty, it capitalizes the exploration and developments costs incurred for thatpropertyasanasset.Ifthefairvalueofapropertyexceedsthecapitalizedcosts,theaccounting rules do not allowWhiting to revalue the property upwards. Thus, ifWhitinghasaluckystrikeorifthepriceofoilskyrockets,Whitingwillhaveaverylowbook-to-marketratio.ThishasnothingtodowithWhitingbeingoverpriced.Itarises simply because the accounting rules fail to reflect the intrinsic value ofWhiting’s oil and gas properties, making book value a poor measure of intrinsicvalue.Theaccountingrules,however,arenotsymmetric. IfthefairvalueofWhiting’soilandgasproperties falls,Whitingmayhavetorecordanasset impairment.But theaccounting here is notmark-to-market.Whiting is onlymeant to record an assetimpairment when the undiscounted recoverable cash flows from the oil and gasproperties fall below the carryingvalue.Once this criterion ismet, thepropertiesarerequiredtobeimpairedtofairvalue.Forassetssuchasoilandgasfields,where

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the life of the properties is often 10 years or more, there is typically a largedifference between the amounts for the undiscounted future cash flows and thediscounted future cash flows. Thus, the accounting system has a built in lag,whereby impairments are delayed until and unless the recoverability test isbreached,andthenalarge‘catchup’impairmentisrecorded.TheWhiting case study highlights twomajor pitfalls of using the book-to-marketratio to identify underpriced stocks. First, the accounting rules typically requirenonfinancial assets tobe recordedat amortized cost, regardlessofhowprofitablethe assets may be. For companies that are fortunate enough to develop highlyprofitableassets,bookvaluewillsignificantlyunderstate intrinsicvalue.Examplesrange from the discovery of a lucrative oil field to the development of a highlypopular smart phone. The second pitfall of the book-to-market ratio is that evenwhentheintrinsicvalueofanassetdropswellbelowitsbookvalue,anaccountingimpairment may not be required. Moreover, if impairment is required, it willtypicallyoccurwithasignificantlagtothedeclineinintrinsicvalue.Oneofthemainculprits here is thatmany long-lived assets are not required to bewritten downuntiltheirbookvaluedropsbelowtheirrecoverable(i.e.,undiscounted)futurecashflows. Moreover, considerable management discretion is often involved inforecasting future cash flows. So even for assets like indefinite-lived intangibles,wherea fairvaluecriterion isused for impairment,accounting impairmentsoftenlageconomicimpairments.14CaseStudy2:BigFiveSportingGoodsBigFiveSportingGoodsisasportinggoodsretaileroperatingintheWesternUnitedStates.Itsellsgoodsprimarilythroughitschainofover400company-ownedstores.During late2016andearly2017, thestockof thiscompany lookedveryattractiveusing a generic multiple factor model approach. Table 4 lists the values of sixfinancial ratios that arepopular in thesemultiple factormodels.Viewed from theperspective of the quants, Big Five is firing on all cylinders, ranking above themedian on all sixmetrics. It has a rare combination of a cheap valuation, strongmomentumandhighquality.Itisnotsurprisingthen,thatBigFivewasthedarlingofinvestmentstrategiesusingamulti-factorquantitativeapproach.Table5liststhetopteninvestorsinBigFiveasofMarch31,2017basedon13-FfilingswiththeSEC.Thislistisawhose-whoofbigquantitativeinvestors.15Thetopholder,Blackrock,isthe dominant player in factor-based ETFs. Not far behind are Dimensional FundAdvisors, Numeric Investors, LSV Asset Management, Arrowstreet Capital, andAcadian Asset Management, all of whom specialize in implementing ideas fromacademicfinance.1614SeeRamannaandWatts(2012)andLiandSloan(2017).15IidentifiedBigFivefromwork-in-progresswithSteveSloanandJieyinZhenginwhichweanalyzethetopholdingsofthemajorquantitativeinvestors.BigFivetoppedourlistashavingthehighestproportionofitssharesownedquantsasofMarch31,2017.16ThefinalcolumninTable5indicatestheownershipinterestthateachinvestorinBigFivewouldhaveifitheldeachstockonacapitalization-weightedbasis.Vanguardappearsinthetoptenby

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Table4.FinancialRatiosforBigFiveSportingGoodsversusComparableInvestmentUniverseat3/31/2017.Ratiosusepricesat3/31/2017andfinancialstatementsforthe2016fiscalyear,whichendsonDecember31,2016forBigFive.TheFactsetU.S.MarketIndexRepresentstheComparableInvestmentUniverse.Source:Factset.Ratio:

AssociatedFactor

Big FiveSportingGoods

UniverseLowerQuartile

UniverseMedian

UniverseUpperQuartile

TrailingEarnings-to-Price Value 0.051 0.002 0.035 0.053Book-to-Market Value 0.616 0.234 0.425 0.66112 Month StockReturn Momentum 39.8% 5.5% 22.9% 45.1%ReturnonEquity Quality 0.084 -0.029 0.083 0.166DebttoEquity Quality 0.065 0.181 0.631 1.250MarketCapitalization LowSize 333 550 1,620 5,143RestatedRatio Restated ReturnonEquity* Quality 0.039 -0.018 0.053 0.111Restated Debt toEquity** Quality 1.500 0.371 0.847 1.578*RestatedreturnonequityreplacesnetPP&EwithgrossPP&Einthecomputationofcommonequity.**Restated debt to equity incorporates the constructive capitalization of operating leasecommitmentsusinga5%discountrateandassumingthatamountsduebeyond5yearsarespreaduniformlyoverthenext5years.With a low valuation, strong momentum and high quality, what is not to like?Apparently something, since while the quants were buying, two other distinctgroups of investors were actively selling. First, the short position in Big Fiveexplodedfromaround5%ofthefloatinthefallof2016toover40%ofthefloatinMarch of 2017. Secondly, Stadium Capital, Big Five’s largest pre-existingstakeholder, unloaded its entire 13% stake between June 2016 andMarch 2017.

virtueofitssheersizeandactuallyholdsanunderweightinBigFive.TheotherinvestorsallholdsignificantoverweightsinBigFive.Oftheremaininginvestors,Principal,MilleniumandGeode,alloffersomequantitativeproductsbasedonideasfromacademicfinance.Notlisted,butmakingitintothetop25,areseveralotherwellknowquantitativeinvestorswithsignificantoverweightsinBig5,includingRenaissanceTechnologies,TwoSigmaAdvisors,TwoSigmaInvestments,BridgewayCapitalManagement,AmericanCentury,BogleInvestmentManagementandAQRCapitalManagement.Alloftheseinvestorsownedatleast1%ofthesharesoutstandingat3/31/2017.

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Stadium Capital, is a hedge fund with a traditional concentrated value investingphilosophythatconductsdetailedfundamentalanalysisonallofitsholdings.17Table 5. Top Ten Largest Institutional Investors in Big Five Sporting Goods at3/31/2017, as compiled from 13-F Filings and sourced from Factset. The FinalColumnReportstheMarketValueoftheInvestor’sTotalHoldingsintheFacstetUSEquity Market Index as a Percentage of the Index’s Total Market Capitalization.Source:Factset.Name Position (000) % Outstanding % Market BlackRock Fund Advisors 3,559 16.16 4.75 Dimensional Fund Advisors LP 1,855 8.42 0.75 Numeric Investors LLC 1,122 5.09 0.04 LSV Asset Management 1,114 5.06 0.21 The Vanguard Group, Inc. 989 4.49 7.04 Arrowstreet Capital LP 875 3.97 0.08 Acadian Asset Management LLC 763 3.46 0.06 Principal Global Investors LLC 662 3.00 0.30 Millennium Management LLC 643 2.92 0.18 Geode Capital Management LLC 592 2.69 0.92 Total 12,174 55.26 14.32 Sowhatisgoingonhere?Havethequantsoutsmartedtheshortsandinsiderswiththeir academic insights, or do the shorts and insiders know something that thequantshaveoverlooked?Itturnsoutthatarathersuperficialfundamentalanalysisof Big Five reveals significant additional insights. Brick andmortar sporting goodretailershadbeen losingmarketshare toonlinecompetitors, suchasAmazon, forseveral years. Big Five was not immune to these competitive pressures and hadalready begun closing stores. Its store count had peaked at 439 in 2014 andwasdownto432bytheendof2016.TwoofBigFive’smaincompetitors,however,hadbeenevenlessfortunate.TheSportsAuthorityandtheSportsChaletbothfiledforbankruptcy in early 2016 and had closed all their stores by late 2016. Big Fivenaturally experienced a boost to sales as customers frequenting sporting goodsstoresnowhadfewercompetitorstochoosefrom.BigFiveacknowledgedasmuchinitsearningsannouncementforthethirdquarterof2016:

“We are very pleased to deliver an exceptionally strong third quarterperformance,withearningsmeaningfullyabovetheprioryearaswellasthehigh end of our guidance range,” said Steven G. Miller, the Company’sChairman, President and Chief Executive Officer. “Results were driven bystrong sales growth, including increases inboth customer transactionsandaveragesale,aswellasimprovedmerchandisemargins,andclearlyreflectedthebenefit from the closureofover200SportsAuthorityandSportChaletstorelocationsinourmarkets.”

17IinterviewedthefundmanagersatStadiumCapitalandtheyconfirmedthattheysoldthestakebecausethepriceinthesecondhalfof2016hadrisensubstantiallyabovetheirinternalestimatesoftheintrinsicvalueofthestock.

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AnotherfactorbenefittingBigFiveintheFallof2016wasthependingUSelection.TheDemocraticcandidate,HillaryClinton,wasfavoredtowinandwasrunningonaplatformthatincludedadditionalrestrictionsonthesaleandownershipoffirearms.FirearmswereoneofBigFive’smostpopularlines,andsaleswerebooming(nopunintended) in the run-up to the November election as gun enthusiast looked topurchaseaheadofanynewregulations.But theelection tookadifferentpathandfearsaboutgunregulationssubsequentlywaned.Given the factors contributing to Big Five’s performance, it is not surprising thatsalessoonresumedtheirseculardowntrend.Bythethirdquarterof2017,bothtotalsalesandsame-storesaleswereindecline.Managementexplainedthesituationasfollowsintheir2017thirdquarterearningsannouncement.

“Giventhechallengingandcompetitiveretailenvironment,wearepleasedtohave retained a significant portion of the market share gains that weachieved following last year’s competitor store closures in our markets.While our third quarter same store sales declined from the prior year,weachievedtwo-yearstackedquarterlysamestoresalesgrowthfortheperiodof 3.8%. For the thirdquarter, same store sales in ourhardgoods categorydeclined in themid-single-digitrange, reflecting the continued reduceddemand for firearm-related products, and same store sales in our apparelandfootwearcategorieswereslightlydown.”

We now can now understand why Big Five had high valuation ratios and strongmomentuminlate2016andearly2017.TheclosureofSportsAuthorityandSportsChaletprovidedabrief respite forBigFive.ButBigFive’s longer runoutlookwaslessrosy.Justlikethewell-knownstoryof‘buggywhip’manufacturersattheadventoftheautomobileindustry,BigFiveisoperatinginanindustrythatisincreasinglyobsolete.Figure2illustrateshowtheclosureofSportsAuthorityandSportsChaletboostedBigFive’sEPS(bottompanel)andstockprice(toppanel).BigFive’sEPShasa strong seasonal component, but you can readily see how EPS in the final twoquartersof ’16and the first twoquarters ’17grewover the samequarters in thepreviousyear.Butyoucanalsoseehowthisgrowthwasshortlivedandapatternofsecular year-over-year declines set in for the last two quarters of 2017. The toppanelshowshowpriceincreasedbyover100%inresponsetothegrowingearningsin the last two quarters of 2016, but then reversed all the gains in 2017 as thegrowthinearningsprovedshort-lived.We can now see why the quants saw Big Five as such an attractive investmentstarting in late 2017. Big Five already looked cheap using simple valuation ratiosbecause of its poor long-term growth prospects. The strong results in the thirdquarter caused by the unexpectedly abrupt closure of its competitors sparked astock price rally,with the stock price doubling between July andNovember. Thismade Big Five look like a greatmomentum stock, and so themulti-factor quantspiledin.Figure3showstheownershiptrendsforthetopholdersofBigFiveasof3/31/2017. The top 25 holders as of 3/31/2017 had increased their ownership

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from just 40% at 9/30/2016 to over 70% by 12/31/2016 and over 80% by3/31/2017.Butasmomentumpeteredout in thesecondhalfof2017, thesesameinvestors starteddumping the stock, taking their ownership down to 50%by theend of 2017. A good illustrative example is Numeric Investors, a well-knownquantitative investor that increased itsownership from0%at9/30/2016 toover5%at12/31/2017andbackdowntolessthan1%bytheendof2017.Figure2.GraphofStockPriceandQuarterlyEarningsPerShare(EPS)forBigFiveSportingGoodsfrom2015to2017.Source:Factset.

WehaveyettotalkaboutBigFive’ssolid‘quality’ratios-itshighreturnonequityand low leverage. Why didn’t these ratios alert quants to the fundamentalshortcomingsofBigFive?Let’sstartwithreturnonequity. IfBigFiveoperated insuch an unprofitable industry, why was its accounting rate of return a relativelysolid 8.4% for 2016? Part of the reason was that Big Five had some temporarypricingpowerduetothesuddenexitofitsmajorcompetitors.Butanotherreasoniswhatfundamentalanalystsrefertoasthe‘oldplanttrap’.BigFivewasinamatureanddecliningbusiness,sotheamortizedcostof itsproperty,plantandequipment(PP&E) significantly understated its original cost. To put this in perspective, BigFive’s book value of PP&E at the end of 2016was $78M (i.e., net PP&E), but theoriginalcostofthisequipmentwas$319M(i.e.,grossPP&E).Moreover,sincemanyofthesecostswereincurredyearsago,thereplacementcostsarelikelytobeeven

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higher.WecanapproximateBigFive’seconomicrateofreturnonequitybyaddingaccumulateddepreciationtothebookvalueofequity.18Doingsocausesthereturnon equity to drop by more than half to 3.9%. Thus, it appears that even in thetemporarilyfavorableretailingenvironmentof2016,BigFivewasnotgeneratingaverygoodeconomicrateofreturn.Figure3.AggregateOwnershipTrendsfortheTopInstitutionalHoldersofBigFiveSportingGoodsasat3/31/2017.Source:Factset.

Wenext turn toBigFive’s extremely conservativedebt-to-equity ratio.Onemightinitially think that Big Five’smain assetswould be all the primeWest Coast realestate onwhich its stores are built. But if thiswas the case, why hasn’t Big Fiveavaileditselfofanymortgagedebttofinanceitsrealestate?Anygoodretailanalystwill immediately know the answer to this question. Likemost other retailers, BigFiveusesoperatingleasestofinanceitsretailstoresites.ThePP&Ethatwetalkedabout in the last paragraph is mostly furniture, equipment and leaseholdimprovements. The good fundamental analyst should immediately identify these18Iacknowledgethatthisisaroughapproximationthatismadehereforeaseofexposition.ThemoretechnicallycorrectapproachwouldbetorestateBigFive’saccountsusingeconomic(i.e.,sinkingfund)depreciation.Whilethisalterativedepreciationmethodproducesaperiodicreturnonequitythatismoreeconomicallymeaningful,itisnotagenerallyacceptedaccountingprinciple.Thegenerallyacceptedaccountingprinciples(straight-lineandaccelerateddepreciation)areconservative,causingaccountingratesofreturntoinitiallyunderstatetheireconomiccounterparts,withthiseffectsubsequentlyreversingforfirmswithagingassetbases.

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operating leases as a form of off balance sheet financing and adjust the debt toequity ratio for the constructive capitalization of the future minimum non-cancelable leasepayments.Doingso increasesBigFive’sdebt-to-equity ratio from0.065(hightopquartile)to1.500(closetobottomquartile). TheBigFivecaseillustratesseveralpitfallsofthegenericmulti-factorapproachtoinvesting.First,theuseofvaluefactorsentailssimilarproblemstothosewesawintheWhitingcaseandexplainedbyKoketal.(2017).Cheapvaluationratiostypicallyidentify firms that are in secular decline and are prone to deterioratingfundamentals.Second,screeningonmomentumdoesn’tnecessarilyeliminatefirmsthat are in secular decline. Even these firms experience occasional periods ofoutperformance due to the exit of competitors or other unexpected short-termshocks. Finally, accounting measures of quality, such as the accounting rates ofreturnandleverageratios,aresubjecttopotentiallysevereaccountingdistortions.The old plant trap is a classic example and it is particularly pernicious formulti-factorquantsscreens,asitbooststheaccountingrateofreturnformaturefirmsinseculardecline.Theexclusionofoperatingleaseobligationsfromleverageratiosisanotherclassicexampleofhowaccountingratioscandistorteconomicreality.Mystudents often question whether there are any investors that are fooled by suchtransparentaccountinggimmickry. Iofferquant fundsusingsimpledebt toequityratiosasameasureofqualityasproofthatthereare.Fortunately, the U.S. accounting rules are about to change to incorporate theconstructivecapitalizationofmostoperatingleases.Thisisagoodexampleofhowimproved accounting can reduce accounting distortions and so protect investorswhorelyonsimpleratios.Perhapsoneday,theaccountingruleswillevenembraceeconomicdepreciation.Butinanever-changingandincreasinglycomplexbusinessworld with ever-present opportunistic managers, I don't see the day whenaccountantswill solve the problem of determining intrinsic valuation and renderfundamentalanalystsobsolete.ConclusionsandImplicationsAdvancesinquantitativefinancehaveproducedmanybenefits.Theseinclude:

1. Loweringthecostofinformationprocessing.

2. Facilitatingthedetectionofsystematicerrorsinsecuritypricing.

3. Facilitatingtheconstructionoflowriskportfolios.4. Facilitatingthedesignandpricingofcomplexfinancialinstrumentsthatcan

enhancerisksharing.Whileacknowledging thesebenefits, Iargue that the focusonquantitative financehas also had negative side effects. Foremost among these is decreased focus on

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fundamentalanalysis in security selection.An important roleof capitalmarkets istheefficientallocationofscarceresources.Forcapitalmarketstoperformthisroleeffectively,themarginalinvestorsmusthavegoodestimatesoftheintrinsicvalueofthe underlying securities. Popular quantitative approaches either ignore intrinsicvalueorusenaïveestimatesofintrinsicvalue.Howdidwegethere?Theoriginalparadigminquantitative financeembracedtheideathatpriceswerealreadyveryclosetoreflectingintrinsicvalue.Sinceattemptstoestimateintrinsicvaluewereunlikelytouncoversignificantmispricing,thetopicwasnot judged to be aworthy of significant academic inquiry. Popular textbooksand ‘investments’courseshaveembracedthisparadigmandpay littleattentiontofundamental analysis. More recently, academics in quantitative finance haveidentified numerous ‘anomalies’,whereby certain accounting ratios have shown arelation to future stock returns. These measures are increasingly being used toconstruct investment strategies that appeal to fundamental analysis, with labelssuch as ‘value’ and ‘quality’ and they claim to offer superior investmentperformance.Thecurrentsituationhasmanyparallelstothepre-GrahamandDoddera,wherebyinvestorsarefixatingonsuperficialaccountingratiosandoverlookingtheimportanceofdetailedfundamentalanalysis.Thisbringsmetomymainconclusions:

1. Good fundamental analysis is essential for the effective functioning ofcapitalmarketsandtheefficientallocationofresources.

2. Goodfundamentalanalysisrequiresinformationthatallowsinvestorstoassesstheamount,timinganduncertaintyofthefuturecashflowsonaninvestment.

3. Goodfundamentalanalysisrequiresanalystswithawidesetofbusiness

skills who can effectively analyze and synthesize both qualitative andquantitativeinformation.

Let me briefly discuss each of these in turn. First, fundamental analysis is muchmore than justanother investment technique.Unlike technicalanalysisandmulti-factorquantitativemodels, theultimategoalof fundamentalanalysis is to forecastthefuturecashflowsandhencethe intrinsicvalueofasecurity. It isonlythroughsound fundamental analysis that capital markets can function effectively andfacilitate the efficient allocation of resources. Some finance academics havedismissedfundamentalanalysisonthegroundsthatitisnotaneasypathto‘beatingthemarket’.Myresponsehereisthattherearenoeasypathstobeatingthemarket.The early days of quantitative finance may have uncovered some systematicinefficiencies,but thesearenowwellknownandunlikely topersist. Fundamentalanalysis, howeverwill endure. The returns to fundamental analysis should followthebasicprinciplesofanycompetitivemarket.Goodfundamentalanalysts,justlikeanygoodMBAgraduate,shouldearnapremiuminthelabormarket.Likeanyother

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market, themarket for fundamental analystsmay experience temporary demandandsupplyimbalances,butIexpectthattherewillcontinuetobeahealthylong-runpremium for the well-trained and industrious fundamental analyst. Being such afundamentalanalyst in today’senvironment includeskeepingabreastof the latestinnovations in quantitative finance. But the ultimate goal continues to be goodestimatesofintrinsicvalue.Mysecondconclusion is thatgood fundamentalanalysisrequires informationthathelps investors determine the amount, timing and uncertainty of the future cashflowsonasecurity.Thelanguageheremaysoundfamiliar,becauseIhaveborrowedit from the FASB’s Concept Statement Number 1 on the objectives of financialreportingbybusinessenterprises.WhatIamsayinghereisthatgoodfundamentalanalysis requires good financial reporting. The disclosure and capitalization ofoperatingleasepaymentsthatIdiscussedearlierisagoodexample.Asaccountingand financeacademics, Idon’t thinkweshould take theposition thatmarketsarealreadysoefficientthatweshouldnotconcernourselveswiththestateoffinancialreporting. Instead, I thinkwe should strive to improve financial reporting so thatmarkets can become even more efficient. There is considerable evidence in theaccountingliteraturethatimprovementsinfinancialreportingleadtoreductionsinthe cost of capital. One thing that I have always found surprising here is that thedevelopment of these improvements is often left to relatively small bodies withlimitedfunding,suchasTheFASBandIASB.Ithinkthatthereisahugeopportunityfortheacademiccommunitytoplayalargerroleinhelpingtocraftfinancialreportsthatenableinvestorstogeneratebetterforecastsoffuturecashflows.Myfinalconclusionisthatgoodfundamentalanalysisrequiresanalystswithabroadset of business skills who can effectively synthesize both quantitative andqualitative information. A good fundamental analyst needs a good knowledge offinance,accounting,economics,strategy,marketingandoperationsjustforstarters.More importantly, a good fundamental analyst needs to be able to integrate thecombinedknowledgefromthesedifferentfieldstogenerategoodforecastsoffuturecashflows.Howmanyofuswhoteachinaccountingandfinancecanevenclaimtohave such skills? Quantitative skills, like the ability to harness ‘big data’ areincreasingly important, but so are qualitative skills, such as being able to identifygood managers and strategies and being able to communicate with managers,suppliersandcustomers.Thegoodnewshere is thatmostofus teach inbusinessschools where we strive to provide our students with just such a mix of skills.Nevertheless, I think that there is still a big opportunity for us as educators andresearcherstodelivercoursesandconductresearchthatbetterintegratesinsightsacrossdisciplines.Let me close by emphasizing that as accounting academics, we are in the primeposition to capitalize on the opportunities identified above. We have the uniqueskillset required toproducebetter financial reporting systems and to trainbetterfundamental analysts. If we are successful, we should significantly enhance the

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